Multiple Deposit Creation and Money Supply Process

With a view to understanding how the Central Banks control the money supply and how
banks operate, the concept of multiple deposit creation has to be understood. Usually the
banking system operates as a fractional reserve system in which only a portion of the bank’s
deposits are held in reserve. Under the fractional banking system the money supply will the
summation of currency in circulation and deposits of the bank. Equation of money supply is

M= C+D

M = Overall supply of money

C = Currency in circulation

D = Deposits

• To simplify the concept when banks receive deposits from Surplus Spending Unit
(SSU) they usually lends certain percentage of deposits and put the rest as reserve
either in the form of excess reserve or mandatory reserve requirements.

• The Central Bank sets a lower limit for the fraction of deposits that must be held in
reserve: the reserve requirement ratio.

• Since banks earn profit by lending at higher interest rates than they give on deposits,
so the reserve requirement is generally a binding limit.

• One way the Central Bank influences the money supply is by changing the reserve
requirement ratio (r).To simplifies when Central Banks increase the reserve ratio then
banks have to put aside larger percentage of deposit rather than lending them at higher
rate.

• To make the analysis easier let assume two scenario such as

Scenario one: Reserve ratio is 100%

Scenario two: Reserve ratio is 10%

Scenario one:

Let us assume that HSBC bank receives deposit of BDT 1,000 from depositors. If the reserve
ratio is 100% set by the Central Bank then HSBC has to put aside the full BDT 1,000
deposits in its reserve without lending. Then the balance sheet of HSBC will be like

HSBC Bank
 Assets Amount Liabilities Amount
Reserve BDT 1,000 Checkable deposits BDT 1,000

Hence, the supply of money is

𝑀 =𝐶+𝐷

𝑀 = 0 + 1,000

𝑀 = 1,000

Here supply of money is exactly equal to the amount of deposit when the reserve requirement
ratio is 100%. So, if the reserve requirement is 100% then the injection of deposits in the
banking sector will not contribute in the supply of money.

Scenario two:

In that scenario let us assume reserve requirement is 10%. Here, initial injection of BDT
1,000 deposits in HSBC will make its balance sheet look like

HSBC Bank

Assets Amount Liabilities Amount

Reserve@10% BDT 100 Checkable deposits BDT 1,000
Loans BDT 900

Say the money BDT 900 lent by HSBC is deposited by the borrower in another bank such as
Standard Bank. Then Standard Bank must keep 10% of BDT 900 (BDT 90) as required
reserves and lend the rest 90% of BDT 900 (BDT 810). Therefore, the balance sheet of
Standard Bank will be:

Standard Bank

Assets Amount Liabilities Amount

Reserve@10% BDT 90 Checkable deposits BDT 900
Loans BDT 810

The balance sheet of Standard Bank would just apply to HSBC, and its total checkable
deposit would increase by an amount of BDT 1,900 (BDT 1,000 checkable deposits in HSBC
and BDT 900 in Standard Bank).

The BDT 810 lent by Standard Bank may be deposited by the borrower in another bank say
(AB Bank). So, the checkable deposit of AB Bank will increase by BDT 810. The must keep
10% reserve requirement of BDT 810. Consequently, the balance sheet of AB Bank will be:

AB Bank
 Assets Amount Liabilities Amount
Reserve@10% BDT 81 Checkable deposits BDT 810
Loans BDT 729

So, the initial BDT 1,000 deposit in HSBC will lead to total deposit of BDT
2,710(BDT 1,000 + BDT 900 + BDT 810). Following the same process if all banks in the
banking system make loans of the all amount of their excess reserve then further increase in
checkable deposits will continue ( say AB Bank, IFIC Bank, EXIM Bank, and so on).

Banks Increase in deposits (BDT) Reserve amount @ 10% (BDT)

HSBC 1,000 100
Standard Bank 900 90
AB Bank 810 81
IFIC Bank 729 72.9
EXIM Bank 656 65.6
. . .
. . .
. . .
City Bank (The last) 0 0
Total 10,000 1,000

The formula of multiple deposit creation in the deposit system can be written as:

ID
D=
rr
D = Deposit

ID = Initial Deposit

rr = Reserve Ratio

Total increase in the deposits in banking system assuming 10% reserve ratio will be:

ID
D=
rr
BDT 1,000
=
0.1
= BDT 10,000

Therefore, the total increase in deposit from the initial deposit of BDT 1,000 will be BDT
10,000 assuming 10% reserve requirement. So, the money multiplier is tenfold of the initial
deposits(10 = 1⁄0.1)